Investing in Private Funds: What You Need to Know

Are you considering investing in a private fund but don't know where to start? With so many regulations in place, it can be tough to keep track of what you need to know. Here's a beginner's guide to private fund investment and the SEC and state regulations you need to be aware of.

What is the SEC's Role in Private Fund Investment?

The SEC, or the Securities and Exchange Commission, is responsible for regulating investment advisers under the Investment Advisers Act of 1940. The Dodd-Frank Act of 2010 altered the SEC's regulatory oversight of investment advisers to private funds. Under the new regulations, the SEC focuses on large fund managers while state regulatory agencies handle the oversight of small and midsize fund managers.

To be exempt from SEC registration, a private fund investment adviser must advise either venture capital funds or funds with assets under management (AUM) of less than $150 million. If a fund advisor meets these requirements or another exemption, they are generally not required to register with the SEC but may still need to register with the state(s) where they offer investment advice.

State Regulation: The NASAA Model Rule

Every investment adviser, unless exempt, is subject to state registration in the states where they provide investment advice. To encourage state regulators to align their rules with the federal government, the North American Securities Administrators Association (NASAA) created a private fund adviser exemption model rule. This model rule serves as a guideline for states.

Under the Model Rule, a private fund adviser is exempt from registration if:

Neither the adviser nor their affiliates have certain disqualifications

The adviser files Form ADV with the state, following SEC Rule 204-4

The adviser pays relevant state fees

For 3(c)(1) funds, the NASAA Model Rule imposes additional conditions:

The fund's securities must be owned entirely by "qualified clients" as defined by SEC Rule 205-3

The adviser must provide written disclosure to each fund owner of all services, duties owed, and other material information

The adviser must deliver annual audited financial statements to each fund owner

Losing the Private Fund Exemption

If an exempt reporting adviser loses their private fund exemption by, for example, adding a client who does not meet the definition of a "qualified client," the adviser must register with the SEC within 90 days.

The NASAA Model Rule also includes a grandfathering provision for 3(c)(1) funds with one or more beneficial owners who are not qualified clients. To be eligible for the exemption, the following conditions must be met:

1. The fund existed prior to the effective date of the state's regulation

2. The fund ceased accepting non-qualified clients as of the regulation's effective date

3. The adviser disclosed the information outlined in Section 2 of the Model Rule

4. The adviser delivered audited financial statements as of the regulation's effective date

State Variations on the NASAA Model Rule

States have the ability to modify the NASAA Model Rule to fit their specific needs. Here are a few examples of state variations:

California substitutes the definition of "accredited investor" under Rule 501(a) of Reg. D for "qualified client" and does not deduct the value of a person's primary residence from their net worth

Colorado allows fund advisers already registered with the SEC to be eligible for the state exemption and substitutes the definition of "accredited investor" under Rule 501(a) of Reg. D for "qualified client"

Maryland does not include "bad boy" provisions as a disqualification from exemption under Section (b)

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